Question

8. Suppose you are a market maker in S&R index forward contracts. The S&R index spot price is 1100, the risk-free rate is 5%, and the dividend yield on the index is 0.

a. What is the no-arbitrage forward price for delivery in 9 months?

b. Suppose a customer wishes to enter a short index futures position. If you take the opposite position, demonstrate how you would hedge your resulting long position using the index and borrowing or lending?

c. Suppose a customer wishes to enter a long index futures position. If you take the opposite position, demonstrate how you would hedge your resulting long position using the index and borrowing or lending?

Answer 1

b) If we are taking opposite position of shorting index futures i.e. longing the index futures then to hedge the position we will short the index and lend the money received from shorting the index at risk-free rate of 5%.

	Today	In 9 Months
Long forward	0	ST - 1142.03
Short index	1100	-ST
Lend S0	-1100	1142.03
Total	0	0

C) If we are taking opposite position of longing index futures i.e. shorting the index futures then to hedge the position we will long the index and borrow the money to long the index at risk-free rate of 5%.

	Today	In 9 Months
Short forward	0	1142.03 - ST
Buy index	-1100	+ST
Borrow S0	1100	-1142.03
Total	0	0